Lessons from global interest rates

Every month economists scramble to predict what the Reserve Bank will do with the ‘official cash rate’.  Since August 2013 the answer has been nothing – with the rate staying at 2.5%.  The cash rate is the interest rate which banks use to borrow from or lend to other banks on an overnight unsecured basis.  The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.

The cash rate as a monetary policy tool

The Reserve Bank seeks to keep inflation in the 2-3% range over the medium term.  Keeping a lid on inflation preserves the value of money and should support strong and sustainable growth in the economy over the long term.

Global interest rates

The central banks in many other countries use monetary policy in a similar way.  In simple terms if an economy is booming inflation may get too high and hard to reign in.  Raising the cash rate will cause other interest rates to rise and slow economic growth.

If an economy is struggling, reducing the cash rate can stimulate growth.  The cost of borrowing will fall, freeing up money for consumption and encouraging investment.

The table shows the cash rates for selected countries in May 2014. 

Note: In the Eurozone inflation varies by country.  Generally it is around 1% but inflation in Germany is 1.3% and in Greece it is minus 1.3%.

What can we learn from global trends?

Interest rates have been falling globally since the late 1990s.  The cash rates for advanced economies are very low – Japan and USA are the lowest and NZ the highest but still at a historical low level.  The cash rates in emerging economies are higher reflecting the continued strong growth and the higher risk – Brazil and India are at the top of the range.

Lesson 1 – There are limits on monetary policy

Reducing cash rates gets less effective once the rate gets to zero or close to zero.  Japan attempted to stimulate its economy after a recession in the early 1990s and maintained a zero interest rate policy until 2006.  This stimulus was insufficient to restore growth and other political and monetary policies were necessary.  The USA and UK have rates close to zero and this and other policies are showing signs of bringing their economies out of the post Global Financial Crisis recessions.  The building industry is recovering in both USA and UK with mortgage rates around 3%.

Lesson 2 – Safety may mean negative returns

Low interest rates are bad news for savers not just because rates are low but because the value of money over time is being reduced by inflation.  If inflation is greater than the interest rate then the ‘real’ return will be negative like in Japan, UK and USA.  In Australia a term deposit with an interest rate of 3% is barely staying ahead of inflation so an investor has capital security but no ‘real’ investment return.

Lesson 3 – Low rates can cause asset bubbles

Low interest rates will stimulate borrowing for consumption and investment.  Debt used for consumption will eventually have to be repaid and can stress households when interest rates eventually rise.  Debt used for investment – such as in property or share investment – can push up asset values to unsustainable levels. 

Lesson 4 – Knock on effects

The integration of financial markets around the world means it is easy for money to be moved to the most favourable destinations.  Although 2.5% is ‘low’ by Australian standards it is relatively high for investors holding US dollars, UK pounds or Japanese yen.  Overseas investors moving money to Australia will cause the exchange rate to rise.  A higher Aussie dollar makes life tougher for exporters and local manufacturers but keeps a lid on inflation because imports are cheaper.

Lesson 5 – Very high or low rates are not good news

The extreme low rates in Japan, USA and UK are a response to recessions and poor economic prospects.  The high rates in Brazil, Russia, India and China are a response to higher levels of growth and inflation.  The recent increase in the cash rate in NZ from 2.5% to 3% was viewed by many economists as a positive.  It meant the NZ economy was performing well and did not need the stimulation of such a low interest rate.

Where to next?

The economists will continue to speculate on the next decision by the Reserve Bank.  The pessimists will point out poor economic trends and advocate further interest rate cuts.  The optimists will recommend rate rises based on positive economic results.  And there will be those that sit on the fence waiting for the global economy to show better signs – after all Australia is only a small player in the world economy and what happens in our economy is largely driven by what happens in the rest of the world.